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Have you considered investing in passively managed funds?

Published On , 29 May 2018 By TOI

Recently at a presentation on passive funds and the ensuing debate on passive investing versus active fund management, a senior fund industry professional made an interesting observation. His take on the debate was this: Suppose you are driving on the road and have your destination in your mind. You have two options. Firstly, you could be one of the disciplined drivers, go with the flow, maintain lane discipline and not push the car too much. The other option is to travel at a higher speed than the average speed of the other cars on the road, shift lanes and gears, and may be you would reach your destination a bit ahead of others.

Investing in passive funds is like the first driver who goes with the flow. In this type of investing the fund manager follows a pre-set benchmark index and mirrors his fund exactly like the structure of the benchmark. He/she has very little leeway to deviate from mirroring the index’s structure.

In contrast, active fund management style is like the second driver where the fund manager has the freedom to construct his/her own portfolio and manage it as per his/her discretion and try to beat the benchmark index. In case of passive style of fund management, the investor takes the fund manager-risk out. This means since the fund is almost perfectly mirroring its benchmark index and the fund manager doesn’t have any discretion with the portfolio, the investor’s investments in the fund is dependent only on how the index performs. And almost nothing to do with the fund manager.

In contrast, in an actively managed fund, the fund manager has substantial discretion to construct and manage the portfolio.

According to industry professionals, another great advantage that passive funds enjoy over actively managed funds is the low expense ratio, that is lower fund management cost. Since this cost is borne by the investor, a lower cost adds up to the amount of money that is there for the investor to invest. “In passive funds, given the low cost structure, more amount goes into the market and participates in the market. With the compounding effect, the final positive impact of the outcome in the long run could be substantial,” said a top fund industry official.

In India, when the fund management costs are compared in regular plans, for passive funds it could be one-third of what an investor would pay for active funds, that is about 33% of costs an investor would pay for active fund management. And in case of direct plans, the costs advantage could be even wider: The investor in a passive fund would pay about 20%-25% of the costs in active funds.

According to fund managers and mutual fund industry officials, every investor should have some part of his portfolio invested in passive funds. While selecting a passive fund, one of the factors that an investor should keep in mind is the nature of the index that the fund is benchmarked to. The index should be a stable one and a well thought out, they say.

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